Trade of the Day: iShares Australia Index ETF (EWA)

If weakness in Chinese stocks confinue, short or play puts on EWA

Those of us in the Northern Hemisphere may forget that it is now summer in Australia. On a trip there last week Slingshot Trader analyst, Wade Hansen, watched the famous “gold pour” at the Perth Mint and enjoyed some well-deserved time in the sun. However, Australia has been on our mind for more than just vacations this year.

Stocks from Down Under have lagged the major indexes in North America and Europe and that trend seems likely to continue as the good news keeps coming in the U.S. and investors rush towards momentum trades. This may present some interesting opportunities for short term profits and a little diversification through a bearish play on Australian stocks. The lag in prices is partially because Australian stocks are very sensitive to growth in China. Australia is a major exporter of raw materials and other goods to the economic giant so although China’s growth is still high it has recently continued to decelerate.

Australian stocks are also very sensitive to the price of base commodities including gold. Despite a shortage of physical gold in places like China and India, the world-wide price of the precious metal has been stalled for a while and seems likely to fall further on the threat of the Fed’s taper. You can see the relationship between Australian stocks and gold prices in the chart below where we have compared the iShares Australia Index ETF (EWA) to the SPDR Gold Trust ETF (GLD).

The correlation between the two assets is not perfect, and periodically gold will diverge and fall against rising Australian stocks. Often enough, these divergences trigger a very sharp reaction lower in Australian stocks. When we use gold for this kind of analysis we are using it as a proxy for mining and metals in general. The entire Australian economy isn’t dependent wholly on gold and mining, but its stock indexes are overbalanced to mining companies in general.

Weak commodity prices have already contributed to a wide-spread slowdown in mining and production in Australia. For example Rio Tinto (RIO), one of the world’s largest mining companies with major operations in Australia, announced last week that they are shutting down another operation (and 1,400 workers) at an Alumina operation in Grove. In light of current conditions, we were very curious to see if the Reserve Bank of Australia (RBA) would cut their benchmark interest rates further on December 2 — they didn’t.

The RBA manages monetary policy a little differently than the Fed does in the U.S. or the ECB does in Western Europe. They have been cutting rates since 2011 but are still holding at 2.5% rather than engaging in a Zero Interest Rate Policy (ZIRP) like the Fed. The goal of cutting rates can be to lower the value of your domestic currency compared to other major currencies around the world. This can give the domestic economy an export advantage but lowering rates has serious risks for the relatively conservative RBA.

The RBA is fighting a battle on two fronts. Australia largely skipped the global recession in 2008 because of export demand from China. Because of that, inflation in the short term is a greater risk and rising property values are becoming a problem. Lowering interest rates may stimulate mining, manufacturing and exports but it would also help inflate a property bubble, which could be much worse than slow growth.

In our opinion is it probably inevitable that the RBA will cut rates again in the future, but that isn’t likely to happen until February of 2014 at the earliest and, like most central banks, the RBA doesn’t like to cut rates until asset prices have started to fall. You can see in the next chart of the iShares Australia Index ETF how the last few rate cuts coincided with short term bottoms in stock prices. This gives EWA some room to move to the downside before the RBA is tempted to intervene.

Australian stocks have already started to fade a little but we think the probability for a much larger decline is significantly increased if Chinese stocks also start to fade. Currently the major Chinese stock indexes are stuck at long term resistance, which seems likely to remain intact in the short term.

Assuming that prices of Chinese equities do start to fade we recommend a conditional order to short EWA once the Shanghai Composite Index crosses below 2050. You can monitor that index on Bloomberg here if you can’t access it through your broker.

Option traders could consider long puts on EWA as an alternative to the short position or even long puts on RIO based on the same breakout benchmark. However, one caution we would add is that implied volatility is likely to ramp up as the decline accelerates, which will increase the cost of the options.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.